Dispatches from a Small Business

A Last Case for Payday Loans

The payday-loan industry, which flourished this past decade on
Arizonans' almost-insatiable need for quick, short-term loans
regardless of their high interest rates, may have to close down in
Arizona unless state lawmakers can be persuaded to ignore voters'
wishes.

Voters last week overwhelmingly rejected Proposition 200, a ballot
initiative financed and written by the loan companies to allow them to
continue charging high interest rates on small loans. That decision
placed Arizona among a growing number of states that have effectively
shut down the payday lenders.

So, payday loans from company A to person B are really popular with both A & B, and the industry has "flourished." But persons C, who don't participate in this market, have decided that, for their own good, A & B need to stop engaging in this behavior. One such third party explains it this way:

Her and voter's actions have effectively limited payday loan companies to charging total interest and fees equivalent to no more than 36% annual interest. OK, you say, this seems like a really high rate. That should be enough, right? Well, the problem comes with fixed costs and loan size. Lets look at an example.

A typical payday loan size and term is about $400 for 18 days (pdf). A typical fee for such a loan is $50, which includes both fixed costs and interest. Wow, annualized that is 250%. Usurious! So would you personally go out and get a payday loan? No way! And that is why voters vote to ban them - they are not good for me personally, so they must not be good for anyone else.

But here is the problem. How do you maintain a storefront and trained people and all the documentation and collection apparatus for less than $50? The same loan at 36% would allow a fee of only $7.20. That barely even covers paying someone to originate the loan at the counter, much less pay interest and a risk premium.

Try going to the bank and getting a home loan or some other type of loan for only a $50 fee. Granted those loans are more complicated, but in turn you will likely get charged hundred and probably thousands of dollars in fees. There is a large fixed cost component to the act of lending which we tend to ignore on larger loans, but is there none-the-less. In fact, just try to go to a bank and get a loan for $400 at all. They don't make them, outside of the credit card industry, which solves this problem in part through economies of scale and in part through cost-shifting costs to merchants, options not really available to payday loan companies.

And so far, we are only talking about fixed costs, not the underwriting risk of extending loans to about any person who wanders in the door and can sign his/her name. Anyone remember sub-prime mortgages? Maybe there is a justification for large risk premiums, after all, on loans to under-qualified borrowers. Particularly when you consider that most payday loan customers could not qualify even for a sub-prime mortgage.

The best equivalent to a payday loan offered by banks is overdraft protection, where the bank will go ahead and pay out on checks where there are insufficient funds, though they will charge a $20-$30 fee per check paid. As you can see, these fees are very similar in magnitude to those charged by payday loan companies, particularly when you consider that these fees are generally charged on checks that average about $150. Also, folks who get one overdraft fee usually get several in a row. People are willing to pay these fees because they are in fact lower than the fees of actually having a check bounce, which can incur similar fees from merchants as well as hurting one's credit.

So, you just had to write three checks to get the power and water and telephone turned on, and you are pretty sure the money is not there in your checking account. You are facing $80 in bounced-check (NSF) fees or overdraft fees. Now might you consider a $400 loan for a $50 fee? Well, probably the answer is still no, you would put it on your credit cards. But everyone doesn't have credit cards, or doesn't qualify for them, or don't have a lifestyle that allows for them. Where do they go, short of Tony Soprano?

Update: A reader sent me a link to this report, comparing payday loan rates to overdraft protection, and finding them of similar magnitude. The author calculates an average $28.61 overdraft fee on an average $155 bounced check yields an APR of 478%. There is a fixed cost to lending, and small very short term loans cost a lot of money, no matter how you get them.

I will remind folks not to be fooled by 18% or 23% rates on credit cards and set that as the market rate for small loans. First, this misses annual fees for the cards. But more importantly, it misses merchant fees. Merchants pay between 2.5% and 3.5% of everything you charge to the credit card companies. This helps to subsidize rates and, particularly, subsidize the fixed costs of small lending transactions.

Comments

I always wondered, what do merchants get out of the deal in accepting credit cards and their fees? Besides the obvious one of just getting the business of a person that's not carrying cash on them. Do the credit card processing companies offer some other incentive for the merchants?

I know AMEX and Discover charge higher fees than other cards, which is why they're often not accepted by merchants.

If you asked most people what the risk premium on a loan is, they'd probably stare back at you blankly. Most people do not grasp the risk/reward relationship, nor the need for a risk premium to compensate for the perceived riskiness of some investment.

Combine this with the "rich taking advantage of the poor" narrative and voila, C will make sure there are no payday loans in his/her state!

Posted by: GU | Nov 10, 2008 11:18:13 AM

It would be a shame if this service closed down. while there are some people who utilize it when they don't need it, there are others who use it wisely and it's important to know about them.

Like most small business owners, I always factored the cost of merchant fees into the prices for my goods. Effectively, then, the non-card customers were partially paying for a service provided to the card customers.

I briefly considered charging a fee for credit card transactions. But there was no real reason to do so. Non-card customers weren't complaining becuase prices are 1 to 2 percent higher.

FYI, I sold my retail business in August after 15 profitable years of operation.

Posted by: John Dewey | Nov 10, 2008 12:52:52 PM

Here in Ohio they voted for the payday loan proposition which changed the limit from $800 to $500, interest at no more than 28% (before it was something like 36%), and minimum repayment time to 30 days (previously was two weeks). The very next day, one of the big lenders announced it was shutting down all of its offices and laid off something like 150 people. Another lender has since announced that they are now trading gold for cash.

Posted by: Brian | Nov 10, 2008 1:22:16 PM

Great. Now they will start going after overdraft protection fees.

Posted by: Reformed Republican | Nov 10, 2008 1:40:59 PM

I voted against this as an employer who has had my business affected by an employee getting one of these loans.

The payday loan store never verified his employment or ability to repay the loan. When he failed to do so, they issued a levy against his wages, which requires extra administrative work for us. When he never made enough money for the levy to kick in (anything he made went to a child support order), they took us to court.

His inability to live within his means, and the payday lenders neglect at verifying the likelihood of repayment, resulted in loss of time and money from my business.

That is just the most recent one we have had to deal with.

I am "C" and I voted to stop lender "A" from doing business with person "B" - because, as it stands, they can drag me into their transaction without my knowledge or consent.

I'm confused. How did Prop 200 ban payday loans? The wording of the prop was that it would create new regulations for the industry. Voting no meant that the current regulation would stay in effect until 2010, at which point it would expire. From the wording of the prop, I thought that a "yes" vote would have had the effect of posing additional restrictions and a "no" vote would maintain the status quo and eventually lead to less regulation of the payday loans. I tried to choose the most free market vote - how exactly did this end up being the result.

I hate these stinking ballot initiatives.

Posted by: a. depaul | Nov 10, 2008 2:57:33 PM

So unless I'm missing something here, the solution (if you're a payday lender) is pretty simple: 36% interest plus a $50 'processing' fee, or whatever you want to call it to handle the clerical work.

Posted by: James | Nov 10, 2008 5:18:19 PM

James,

Yeah, I think you're missing something with your pretty simple solution. Why should we allow government - or the majority of the population - to take away the freedom of two parties to set the terms of trade in goods and services?

Posted by: John Dewey | Nov 10, 2008 6:45:08 PM

@ John Dewey

Oh, I completely agree with you. But, it's already been done. You can piss and moan about it (or go get it on the ballot for the next election and try to overturn it) or you can just give them the finger and use a work around like I provided (unless, of course, I missing something big, like them not allowing processing fees).

Posted by: James | Nov 10, 2008 7:13:50 PM

I will point out again that this isn't limited to two parties setting terms for goods and services. The terms are explicitly linked to an employer and, in case of default, require an employers participation (and time & money) - without the ability to refuse.

This isn't like a title loan where they are putting up something they own - they are putting up something I own.

You can get into the number of borrowers who get deeper and deeper in debt, many eventually ending up in bankruptcy (which also affects the rest of us). However, my main point is that the specific act of originating a "payday" loan involves not the two parties, but the two parties AND the borrower's place of employment.

Excuse my ignorance (never used a payday loan) but how are they able to hold you liable for the unilateral actions of a third party (your employee)? This would seem horrendously unfair.

Posted by: James | Nov 11, 2008 12:35:32 AM

Your breakdown of where the fees actually go and the amount of interest a borrower actually repays is right on the mark. The industry has no chance to survive with a 36% cap. I think many voters who also borrow failed to realize that. I also agree that people see the non-applicable APR and think if it's not gooe for them it's not good for anyone. They haven't done any research on the subject. I feel bad for the thousands that may find themselves jobless and for the large group of borrowers that will eventually find themselves optionless when it comes to getting a fast, short term loan to meet unexpected events.

By basing their ability to get a loan on the amount of money they are being paid by their employer, they get a fast track to a levy upon default of that loan.

As I said in my earlier comment; the levy I have to process costs me time & money, going to court to defend my business when the employee doesn't make enough to satisfy the levy costs time & money. The only collateral a borrower puts up for a payday loan is his supposed ability to continue receiving a paycheck. In the recent example I cited above, the employee didn't make enough to begin with and the bulk of anything we pay him is used to satisfy a child support order. We had no hand in his taking out the loan, yet we have had to deal with it repeatedly over the last several months.

An employer is an unwitting third party, and we make nothing on the transaction.

Specifically here in AZ, I'll be very interested to see what happens with this issue. As many of us know, the payday loan services that everyone seems to hate are used out here very commonly to convert paychecks into cash for illegal Mexican workers. In many ways, it's one of their only options, so completely shutting down these establishments will have a huge effect on how they're able to live. To a lot of people, that's actually a good thing because they don't want illegal immigrants here anyway, but the fact of the matter is that we need their services as a labor force and they, in turn, need check cashing and payday loan services to survive.

Posted by: Vern M | Nov 11, 2008 10:33:16 AM

I hate how people are trying to control me. If I want to use a payday loan then I should be able to. If you don't like the intrest rate then don't use them.

everyone makes such a big deal about high interest rates, and htat people should just go to bank to get a loan...well...if they could im sure they would! the face is that many people have bad/no credit and cant get a loan from a bank, payday loans are their only option.

A new Dartmouth study that looks at the effect of Oregon's decision to effectivley chase payday lending out of state, suggests legislators have done more harm than good. Without access to short term credit, there have been more bounced checks, late bill payments, etc. The report compares Oregon to neighboring Washington which still has payday and the results are night and day.

Great, it,s rally a wonderful information and I agree with you that "The best equivalent to a payday loan offered by banks is overdraft protection, where the bank will go ahead and pay out on checks where there are insufficient funds, though they will charge a $20-$30 fee per check paid.."

Great, it,s rally a wonderful information and I agree with you that "The best equivalent to a payday loan offered by banks is overdraft protection, where the bank will go ahead and pay out on checks where there are insufficient funds, though they will charge a $20-$30 fee per check paid.."

GU, I completely agree with you. Payday loans are a viable resource for many people, but unfortunately there are people who haven't used them in a responsible manner and not paid their loan back on time, resulting in more fees.

I work with Check 'n Go and part of my job is to see what conversations are taking place about the payday loan industry. If you have any questions, please feel free to ask or visit www.checkngo.com for more information.

GU, I completely agree with you. Payday loans are a viable resource for many people, but unfortunately there are people who haven't used them in a responsible manner and not paid their loan back on time, resulting in more fees.

I work with Check 'n Go and part of my job is to see what conversations are taking place about the payday loan industry. If you have any questions, please feel free to ask or visit www.checkngo.com for more information.

GU, I completely agree with you. Payday loans are a viable resource for many people, but unfortunately there are people who haven't used them in a responsible manner and not paid their loan back on time, resulting in more fees.

I work with Check 'n Go and part of my job is to see what conversations are taking place about the payday loan industry. If you have any questions, please feel free to ask or visit www.checkngo.com for more information.

GU, I completely agree with you. Payday loans are a viable resource for many people, but unfortunately there are people who haven't used them in a responsible manner and not paid their loan back on time, resulting in more fees.

I work with Check 'n Go and part of my job is to see what conversations are taking place about the payday loan industry. If you have any questions, please feel free to ask or visit www.checkngo.com for more information.